Employee Stock Ownership RONALD L. Ludwig ESOPS-Employee Stock Ownership Plans-are designed to give the participating employee a stake in the financial success of the employer's business while, at the same time, providing an innovative approach to solving various corporate financing problems. Structuring such a stock bonus plan is the subject of this article which points out and cautions against the pitfalls of misusing the ESOP technique. Introduction The use of Employee Stock Ownership Plans, often referred to as "Kelso Plans," has become increasingly popular in the past few years, as both a technique of corporate finance and an attractive employee benefit program. Employee Stock Ownership Plan (“ESOP”) financing utilizes an employees' trust, qualified under Section 401(a) of the Internal Revenue Code, as a vehicle for financing corporate growth and transfers in ownership of corporate stock, while building ownership into the participating employees of the employer corporation. Stock bonus trusts (a basic element of ESOP financing) were first granted tax-exempt status under the Revenue Act of 1921, but were not widely used until recent years. In 1956, San Francisco lawyer-economist Louis O. Kelso first designed a qualified employees' trust as a financing vehicle, thereby pioneering the ESOP concept as a new technique of corporate finance. Largely through Mr. Kelso's continued work over the past twenty years, ESOP financing has become a recognized vehicle for providing employee stock ownership. Congress has recently encouraged the use of the ESOP technique under the Regional Rail Reorganization Act of 1973, the Employee Retirement Income Security Act of 1974 ("ERISA"), the Trade Act of 1974, and the Tax Reduction Act of 1975. * J.D., University of Michigan Law School. Mr. Ludwig is with the law firm Kelso, Ashford & Ludwig, San Francisco. No. 3 ESOPS After ERISA An ESOP Financing Model 475 The basic use of the ESOP technique is for financing new corporate capital formation, through debt repayable with pretax corporate dollars. This transaction is commonly structured as follows: The corporation establishes an ESOP, designed to qualify as an employee stock ownership plan under Sections 401(a) and 4975 (e) (7) of the Internal Revenue Code. The ESOP includes as participants a nondiscriminatory group of employees, whose relative interests under the ESOP are generally in proportion to their relative compensation during the period of the financing. The corporation arranges for a loan (from a bank or other lender) to the ESOP. The ESOP Committee (normally appointed by management) directs the ESOP Trustee to invest the loan proceeds in newly issued common stock of the corporation, at its current fair market value. The corporation now has additional funds necessary for financing its expansion and operations. • The ESOP gives its note to the lender, which note may or may not be secured by a pledge of the stock. If the loan is so secured, the pledge is designed for release of proportionate amounts of stock each year, as repayments on the loan are made to the lender. 476 EMPLOYEE RELATIONS LAW JOURNAL Vol. 1 • The corporation issues its guarantee of the loan to the lender, assuring that it will make annual payments to the ESOP in amounts sufficient to enable the ESOP to amortize debt principal and interest due to the lender. Within the limits specified under Code Section 404(a), such payments are tax deductible by the corporation as contributions to a qualified employee deferred compensation trust. Thus, the lender has the general credit of the corporation to support repayment of its loan, plus the added security resulting from the fact that the loan is repayable with pretax corporate dollars. If necessary, the corporation may pledge its own assets as additional security for the ESOP loan. Each year, as a payment is made by the corporation to the ESOP and repayments on the debt are made to the lender, there is allocated proportionately among the accounts of the participating employees a number of shares of stock proportionate to each participant's allocated share of the payment. This permits the employees to acquire stock ownership interests in increments over a period of years at a price fixed at the time the block of stock is first purchased. Special allocation formulas have been designed to counteract the relatively high proportion of early debt amortization payments used to pay interest and the relatively high proportion of later amortization payments used to pay principal. • As the financing is completed and the loan repaid to the lender, the beneficial ownership of the stock accrues to the participating employees. Most ESOPs are designed to permit the withdrawal of stock in kind, subject to vesting provisions, at retirement, death, or other termination of employment. Favorable tax treatment is allowed for lump sum distributions of employer stock under Code Section 402(a)(2) and (e). • The ESOP may be designed to permit dividend income on shares of stock that have been paid for by the financing process (and are then allocated to employees' accounts) to be distributed currently to the employees, thus giving them a second source of income through their capital ownership. During the financing process, dividends may be applied to accelerate the repayment of the ESOP loan. • Voting rights on shares of employer stock held by the ESOP may be exercised by the ESOP Committee, or may be passed No. 3 ESOPS After ERISA 477 through to the employees as shares are allocated to their accounts (or as allocated shares become vested). • After the ESOP has repaid its debt to the lender, additional debt financing may be arranged to finance new capital growth of the employer. Alternatively, the ESOP may be used to create an “in-house” market for stock of the corporation, by acquiring shares from existing shareholders (including former ESOP participants). • Diversification of investments under the ESOP can be achieved, if desired, after a particular block of stock has been paid for, by exchanging a portion of the employer stock, at fair market value, for other investments of equal value. Since the ESOP Trust is a tax-exempt entity under Code Section 501 (a), such diversification is without tax impact. • If the ESOP is to serve as an "in-house" market for stock of the corporation, it is desirable to maintain sufficient liquidity to provide funds for the repurchase of stock from former ESOP participants. • Through the technique of ESOP financing, nonrecourse corporate credit has been extended for the benefit of employees, enabling the corporation to finance its capital requirements with pretax dollars. ESOP financing builds beneficial ownership of common stock into employees, on a tax-sheltered basis, without any personal investment risk and without requiring any reduction in their take-home pay. Requirements of IRC and ERISA As a qualified employees' plan, the ESOP is designed to satisfy all applicable requirements of Section 401(a) of the Code, including the new requirements imposed by ERISA. The ESOP must be a plan for the benefit of employees in general and may not discriminate in favor of officers, shareholders, or highly compensated employees. In addition, ESOP financing transactions must satisfy requirements for the special exemptions from the prohibited transaction rules of ERISA. Code Section 4975(e)(7) and ERISA Section 407(d)(6) define "employee stock ownership plan" as a stock bonus plan, or a combination stock bonus and money purchase pension plan, qualified 478 EMPLOYEE RELATIONS LAW JOURNAL Vol. 1 under Code Section 401(a), designed to invest primarily in employer stock, and meeting such other requirements as the Secretary of Treasury may prescribe by regulation. Guidance for regulations defining ESOP comes from the legislative history under the four laws which Congress has enacted relating to ESOP financing. Congress has recognized and defined ESOP as a technique of corporate finance which is designed (1) To meet general financing requirements of the corporation, including capital growth and transfers in the ownership of corporate stock; (2) To build into employees beneficial ownership of stock of their employer (or its affiliated corporations), substantially in proportion to their relative incomes, without requiring any cash outlay, any reduction in pay or other employee benefits, or the surrender of any other rights on the part of such employees; and (3) To receive loans or other forms of credit to acquire employer stock, with such loans and credit secured primarily by a binding commitment by the employer to make future payments to the ESOP in amounts sufficient to enable such loans to be repaid. As a qualified stock bonus plan, the ESOP may be designed with a discretionary contribution feature and with reallocation of forfeitures to remaining participants. However, any debt service requirements under ESOP financing will create a definite liability for employer contributions. That portion (if any) of an ESOP which constitutes a money purchase pension plan must include a definite contribution formula (subject to the funding standards of Code Section 412) and must provide that forfeitures be applied to reduce employer contributions. Differences From Other Qualified Plans Section 1.401-1(a)(2)(iii) and (b)(1)(iii) of the existing Income Tax Regulations state that a stock bonus plan is established to provide benefits similar to a profit-sharing plan, except that such benefits are distributable in stock of the employer and that contributions are not necessarily dependent upon profits. The following 33-902 O 78 28 |